Paychex Inc. (PAYX) reported second-quarter fiscal 2011 earnings of 37 cents per share, beating the Zacks Consensus Estimate by two cents. The quarter’s results are indicative of an improving client retention rate and the company’s efforts to improve selling operations.
Paychex reported second-quarter 2011 revenues of $512.0 million, surpassing the Zacks Consensus Estimate of $511.0 million and up 3.1% from the $496.6 million reported in the year-ago quarter. The revenue upside can be attributed to year-over-year growth in both checks processed per client and the retirement services client base.
Payroll Service segment revenues increased 1.1% from the year-ago quarter to $354.8 million, attributable to a 2.5% growth in checks processed per client and an increase in pricing per check. However, the Payroll client-base fell 2.2% from the year-ago quarter. Paychex stated that the improvement in checks per client was primarily driven by an increase in corporate hiring and a higher retention rate.
The Human Resource Services segment generated $145.2 million in revenues, up 9.8% from the prior-year quarter. Both the number of client employees served and the number of clients grew in the last quarter, contributing to the increase. The relatively strong performance was on account of the positive impact of the recently passed Health Care Reform Act in the U.S., as well as from increased hiring and retirement expenses per employee.
Operating Results
In the second quarter, Paychex incurred total operating expense of $308.1 million, up 1.5% from the year-ago quarter. Total expense increased due to the company’s continued effort to train sales personnel, provide better customer service and enhance technological infrastructure. However, the increase was partially offset by a higher utilization rate and lower headcount.
Operating income was $203.9 million, up 5.6% from the year-ago period, attributable to modest revenue growth and better cost management. Operating margin increased 90 basis points year over year to 39.8%.
Net income of $133.9 million in the reported quarter increased 6.4% from $125.8 million in the prior-year quarter. Net income per diluted share was 37 cents compared with 35 cents in the year-ago quarter.
Balance Sheet & Cash Flow
Paychex exited the second quarter with cash and cash equivalents of $233.2 million, down from $272.9 million at the end of the prior quarter. Corporate investments increased $53.1 million to $230.3 million. Additionally, during the second quarter, interest on funds held for clients decreased 11.8% year over year to $12.0 million as a result of lower average interest rates earned, partially offset by a 3% increase in average investment balances.
Cash from operations grew from $92.5 million in the prior-year quarter to $124.9 million in the reported quarter. Capital expenditures also increased $14.5 million to $27.5 million.
Guidance
For fiscal 2011, Paychex expects Payroll Service revenues to increase in the range of 1%–2% from the year-ago quarter (previously flat year over year). Human Resource Services revenues are expected to increase in the range of 10.0% to 13.0%. Total service revenue is likely to grow in the range of 3% to 5%. Interest on funds held for clients is expected to decrease in the range of 12% to 17%, while net investment income is likely to increase in the range of 29% to 32% (previously 24% to 27%).
Interest on funds held for clients and investment income for fiscal 2011 are expected to be impacted by the low interest rate environment. However, investment income is expected to benefit from the ongoing investment of cash generated from operations.
Net operating income is expected to be 36% (previously 34–35%) of total service revenue. The effective tax rate is expected to be roughly 35%. Moreover, net margin is projected between 4% and 6%.
The guidance for fiscal 2011 does not include any anticipated results from Paychex’s recent acquisition of SurePayroll Inc. However, anticipated earnings dilution is expected to be approximately 1 cent per share due to amortization on acquired intangible assets and one-time acquisition costs.
Recommendation
Paychex witnessed a modest improvement in the quarter’s results on increasing headcount and price per employee. Despite economic uncertainties and low interest rates, Paychex provided an encouraging guidance. Considering the improving business trends, the company raised its guidance for Payroll Services revenue, Investment Income and net operating margin.
Some analysts believe that there are downside risks to forward earnings estimates, given the lower contribution from new business that has been impacted by the fall in small business employment and lower interest rates earned. Since small businesses make a major contribution to the company’s total revenue, we remain unsure about when Paychex could return to double-digit revenue growth. However, we look forward to a positive contribution from Paychex’s Human Resource Services segment, as there has been a steady increase in clients over the past few quarters.
However, we remain concerned about escalating competition in the outsourcing space from big players such as Automated Data Processing Inc. (ADP) and Administaff Inc. (ASF). But we expect the SurePayroll acquisition to provide Paychex with additional small business market share and revenue growth.
Currently, Paychex has a short-term Buy recommendation, as is indicated by the Zacks #2 Rank.
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